Wednesday, August 4, 2010

Nominal GDP Targeting: the 24-7 Solution

Though I’m skeptical of some of his specific proposals, Scott Sumner has convinced me that nominal GDP targeting is the way to go. I’d like to propose the following law:

The Board of Governors of the Federal Reserve System shall conduct monetary policy in such a way as to increase the nominal gross domestic product to approximately $24 trillion in the year 2017.

I choose 2017 because it’s 10 years after the end of the last growth cycle, and I choose $24 trillion based on an approximate extrapolation of the growth rate from 1997 to 2007. (You get why I like the numbers 7 and 24, right?) This is essentially a retroactive 10-year plan for monetary policy, but it leaves all the details up to the Fed.

I’m proposing this as a law to be passed by Congress, because it’s a little bit easier for me to imagine Congress passing such a law than the Fed making such a radical change on its own. Moreover, it would have more credibility if it were written into law rather than merely an announced policy of the Fed. It does take away a little bit of the Fed’s independence, but, as Dr. Phil might say, “How’s that independent central bank thing workin’ out for ya?” It fully retains the Fed’s operational independence, and it mandates an objective based on what the Fed was already achieving over the 10 years up to 2007 (and very roughly for the prior 10 years as well).

The law would need some sort of enforcement provisions, too, but these need not constrain any specific Fed actions. The Chairman would simply have to explain to Congress, on a regular basis, how the Fed plans to get from here to there. If the plan misses in the early years, it obviously has to become more aggressive in the later years – which is the whole point: the worse things get, the more dangerous it should become for banks, businesses, and individuals to keep sitting on cash instead of investing it. (If you want to give the Fed governors a bonus based on how close they come to the target, I’m down with that, too.)

After 2017, the Fed would be free to go back to its discretion in setting long-range policy goals. But it will have an incentive to continue nominal GDP targeting. It may even ask Congress to pass another law. What incentive? To make up for the abysmal performance of 2008-2010, the 2017 goal will almost certainly require the Fed to allow an inflation rate greater than 2% – possibly much greater than 2% – as 2017 approaches. The Fed will then need a credible way to bring the inflation rate back down. What could be more credible than a promise to continue the nominal GDP pattern of the past 20 years? (Remember, the $24 trillion goal for 2017 was based on an extrapolation of the 1997-2007 trend..)

I would hope that the Fed would then elect to continue with nominal GDP targeting. In the longer run, it’s a policy that solves the problem I discussed when I wrote about inflation targets and financial crises. A financial crisis will (if history is any guide) reduce expectations of real growth. If the Fed is targeting nominal GDP, then inflation expectations should automatically increase when real growth expectations decline. This automatically gives the Fed more room to cut the real interest rate so as to clean up the economic fallout from the financial crisis. And nominal GDP targets should also help prevent such crises by reining in real growth that is driven by speculation rather than actual improvements in productivity. In such cases, inflation may not accelerate, but nominal GDP will, and this will automatically lead to an expectation of Fed tightening. Aside from the arbitrary connection with the numbers 24 and 7, nominal GDP targeting is a 24-7 solution in the sense that it reliably provides help in a variety of circumstances.

I’m hoping my law will receive bipartisan – or even tetrapartisan – support. Progressives can see it as a way to make up for the inadequacy of fiscal policy initiatives. Mainstream Democrats can see it as way to consolidate the gains of fiscal policy. Republicans can see it as an acknowledgment that Democratic fiscal policy initiatives were the wrong solution in the first place. And Tea Partiers can see it as a way to get the Fed out of the business of micromanaging the economy. I don’t really care how you sell it; it’s just a good idea. And since all but about 535 of the members of Congress read my blog...

Yes, I’m hoping that Congress will pick up ideas like this from people like Scott Sumner and me, but I’m not expecting it. I’m still long the bond market in my personal accounts. For the sake of the country, though, I’m begging Congress and the Fed. Take my capital gains. Please.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

21 comments:

You give monetary policy too much power. Japan has provided ample evidence that monetary policy is a weak tool at best for generating strong GDP growth. The US is also adding to that body of evidence.

The Fed's current mandates for price stability and full employment are the right prescription for economic growth but with the Fed funds rate at zero, it is nearly out of options, and can be for the indefinite future. The reason QE and low interest rates don't work as advertised are explained here: http://www.newdeal20.org/2010/08/04/the-real-reason-banks-arent-lending-16510/

Even with near zero interest rates, deflation and persistent mass unemployment can exist. The solution is to provide people with enough financial income to meet their savings desires and consume enough to bring the economy to full employment. This can only be achieved with a trade surplus or government deficit. This isn't a theory, but an accounting identity. So if you were to make a law mandating GDP growth, make the tool to use fiscal policy. Let them adjust taxes and/or spending to regulate aggregate demand. It will bring an abrupt end to unemployment unlike monetary policy.

Since we're in a radical mood, I would add there are more goals for an economy than GDP growth. Maybe we should consider other wants like job security, national security, environmental sustainability and others over GDP growth as priority #1.

The Fed has plenty of options, if it's willing to use them. Long-term Treasury bonds are yielding about 4%. The Fed could buy them all, thereby effectively reducing the yield to 0% by replacing them with cash. Don't you think it would have a significant effect on nominal GDP if the Fed bought up the entire national debt? And the Fed is not limited to public debt. It can buy mortgage securities. It can buy commercial paper. It can buy all kinds of high-grade bonds. It can buy foreign currency. It can buy gold. It's just implausible that the Fed could exhaust its options without at least hitting the target.

Theoretically, the Fed might not be able to hit the target without far exceeding it, because the natural interest rate might be lower than the negative of the inflation rate required to hit the target. I find that case implausible, too, though, because it implies a ridiculously low natural interest rate.

Good that you recognize that the Fed could buy longer term debt, it's something Greenspan recently expressed skepticism about here: http://www.msnbc.msn.com/id/38487969/ns/meet_the_press-transcripts

Why does the treasury even need to issue debt and other than to satisfy a law that prevents them from running an overdraft at the fed? Why does the treasury issue long term bonds? A very wonkish paper (http://bilbo.economicoutlook.net/blog/?p=10404) says it is to satisfy private demand for a safe interest bearing assets. By the fed selling longer term tsy secs they keep the investment rate higher than it would be otherwise. If that rate came down would there be that stimulatory effect?

Should the Fed buy the entire national debt, it would be exchanging interest bearing tsy secs with lower interest bearing reserves. That would reduce inflationary pressure in the economy as that interest represents income for market participants.

Mike Norman has suggested that the Fed buy the stock market, your second point (high grade bonds, gold, commercial paper) makes me think of that. You're right in thinking it will stimulate the economy, because it would be an appreciation of value for those asset holders who presumably will presumably then increase their demand from the economy. But why is that preferable to a payroll tax holiday, or a job guarantee/employer of last resort program that would stimulate the economy from the bottom up?

If the Fed bought up the national debt, it would be a huge capital gain for the current owners of the debt, which would far outweigh the income loss to subsequent would-be owners (unless the process created sufficiently large expectations of inflation, in which case current owners would have losses, but in that case the incentive to buy productive assets, and the stimulus induced thereby, would be even stronger).

Personally, I support fiscal policy initiatives too. If I were the King of America, I would do some of both. But fiscal policy has become very unpopular lately.

Good luck with the NGDP Target proposal! I really hope this idea gets more traction.

Now some questions. First,what is your long-run preferred growth rate of nominal GDP? Second, a NGDP target allows for productivity-driven disinflation or even deflation. Are you cool with that? (I am, but was curious to hear your thoughts).

Just to be clear as to what I mean on the second question, consider a permanent productivity shock that increases the productivity growth rate. In order to maintain a NGDP target in such a situation, the inflation rate has to drop as the real output growth increases.

Presumably higher productivity growth would result in rising real wages, so sticky nominal wages wouldn't be a problem, so I would be OK with a lower inflation rate. Of course that conclusion depends on the target NGDP growth rate being high enough in the first place. If I had my choice, I'd probably want a target around 7%, combined with changes in tax laws so that businesses can deduct inflation from their taxable profits. Given the hostility toward inflation in the real world, I would settle for 5%, which I think is suboptimal but high enough to avoid any major problems. The proposal here implies about 5.5%, starting from 2007, just because the growth rate from 1997 to 2007 happens to be about 5.4%, and I rounded up the final target to $24 trillion.

Andy, Thanks for suggesting the NGDP target. Your discussion of using monetary incentives reminded me of some work I did way back in 1989 proposing the use of NGDP futures markets to set policy. A more recent paper (using the CPI instead) was published in Contributions to Macroeconomics in 2006, and actually started out by discussing compensating each Fed official by the accuracy of their policy votes. Here is a blog post where I discuss using market incentives to make policy more accurate:

I don't know Andy, I think the basic idea is sensible in principle but not sure this sort of law actually accomplishes much. I like the idea of level targeting and legal mandate is not a bad idea but...

The first thing is that the enforcement mechanism is weak. Mervyn King has to write letters whenever CPI inflation exceeds 3% YoY. He's been doing it regularly, each time saying inflation will soon come down. He's correct not to tighten but this shows how these sort of targets, without strict enforcement, can be get kind of pushed aside.

Furthermore, if you asked the Fed right now if they thought they were doing enough to meet such a long term target they would probably say they are, yet we still have 9.5% unemployment. Your target really needs to be for shorter horizons. Having a target horizon that is the length of a full cycle needn't stabilize anything, you could hit it with a huge boom followed by a huge bust.

Adam, you have to appreciate the difference between a growth target and a level target. With a growth target, Mervyn King goes to confession and gets absolution, and leaves intending to lead a new life, but he is tempted into sin again. (I'll admit I'm also on the side of the devil in that particular case.) With a level target, there is no absolution. Every time you undershoot, you fall deeper into sin, and eventually we decide that you were predestined to damnation and need to be replaced with a new central banker. (Mind you, I'm not advocating -- nor even claiming to understand -- Calvinist theology as a religious matter, but when it comes to central banking, I think it's preferable.)

I doubt the Fed thinks it's doing enough to meet my target. We've had almost 3 years of below-target core inflation and below-target real growth, for which the Fed would have to compensate. Surely (taking an average of the governors) the Fed believes that there is a significant permanent component to fluctuations in real growth, and nothing the Fed has said suggests that they plan to engineer more inflation to make up for the past 2 years' undershoots. (Indeed, looking at their forecasts, quite the opposite seems to be the case: they plan a few more years of below-target inflation, for which there is no indication that they plan to compensate later.)

I specifically avoided targets for shorter horizons, because I think they are impossible to hit. The Fed needs to get some traction before it can start hitting targets. The way it gets the traction, in my plan, is to say, "Dudes, we may not be able to damage your cash portfolio right now, but once we get the chance, you just watch the hell out! You'd better start moving out of cash pretty soon, or it's going to be too late." Once it gets the traction, which takes a couple of years, it can make good on the threat. And the longer it takes, the stronger the threat becomes.

NGDP is a nominal quantity; unemployment is a real quantity. If the Fed tries to keep the unemployment rate permanently below the true natural rate, you get hyperinflation. If it tries to keep NGDP growing at a rate much faster than real GDP can grow, all you get is a high but constant rate of inflation. I think it actually makes sense to allow for extra inflation to make up for shortfalls in growth of productivity and population. You can think of NGDP as being a "velocity-adjusted money stock" measure, in which case controlling NGDP is basically an extension of the old idea of controlling the money supply.

Very late to this, but if you targeted nominal GDP for 7 years in the future, and then productivity gains were a lot lower than expected, wouldn't you end up with inflation much too high? with all the attendant problems? Or the converse with deflation.

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About Me

I’m an economist specializing in macroeconomics, with particular interests in labor and finance. Since finishing my doctorate at Harvard University in 1994, I have been involved in a number of projects related to economics, including writing econometric software, developing quantitative methods to forecast US Treasury yields, and co-authoring The Indebted Society with James Medoff. My occasional writing has appeared in various publications such as Barron’s and Grant’s Interest Rate Observer. Currently I am Chief Economist at Atlantic Asset Management. Opinions expressed here (as well as any errors or omissions) are entirely my own and do not necessarily reflect those of Atlantic Asset Management or its officers.

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